MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION

1. Session: Three MBF-705LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF

2. Summary of Previous Session • General principles of banking regulation • Minimum Requirement • Supervisory review • Market Discipline • Banking Crises • Banking system (Operations, potential Problems, Criticality) • Institutional investors • investment banks • Pension Funds • Hedge funds • Central Bank. US Example • Government Securities / Bonds

3. Agenda of this session • Credit rating agencies • Mortgage Brokers • Secondary Mortgage Markets • The Mess • Evolution of Home Mortgage • New model of Mortgage lending • Private sub prime mortgage process • Reasons for forming of subprime mess

4. Credit Rating Agency (CRA) • Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves • A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued

5. Credit Rating Agency (Contd.) • Ex: Moody's (U.S.), Standard & Poor's (U.S.) • Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. • For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk.

6. Mortgage Broker • Mainly found in developed economies like US, Western Europe • Professionals who are paid a fee to bring together lenders and borrowers • Sells mortgage loans on behalf of businesses (ex. Banks)

7. Mortgage Broker (Contd.) • Tasks undertaken: • Marketing to attract clients • Assessment of the borrowers circumstances (Mortgage fact find forms interview). This may include assessment of credit history (normally obtained via a credit report) and affordability (verified by income documentation) • Assessing the market to find a mortgage product that fits the clients needs (Mortgage presentation/recommendations)

8. Mortgage Broker (Contd.) • Applying for a lenders agreement in principle (pre-approval) • Gathering all needed documents (paystubs / payslips, bank statements, etc.), • Completing a lender application form • Explaining the legal disclosures • Submitting all material to the lender

9. Sub-prime mortgage – What’s that? • Home loans made to borrowers with poor credit ratings — a group generally defined by FICO scores below 620 on a scale that ranges from 300 to 850

10. Sub-prime mortgage (Contd.) • FICO - a number that is based on a statistical analysis of a person's credit report, and is used to represent the creditworthiness of that person. (FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol "FIC") that created the best-known and most widely used credit score model in the US.) • Creditworthiness—the likelihood that the person will pay his or her debts. Calculated by credit reporting agencies. Ex. Equifax, Experian, and TransUnion in US

11. Secondary Mortgage markets • The secondary mortgage market allows banks to sell mortgages, giving them new funds to offer more mortgages to new borrowers. • If banks had to keep these mortgages the full 15 or 30 years, they would soon use up all their funds, and potential homebuyers would have a more difficult time to find mortgage lenders.

12. Secondary Mortgage markets (Contd.) • Many of the mortgages on the secondary market are bought by Fannie Mae. • Other are packaged into mortgage-backed securities, and sold to investors.

13. Now we are ready to look into the mess !

14. Evolution of home mortgage Home loan funding 1930s Principal + interest payable over long term Borrower-Individuals Lender-Banks • Owning a house was not affordable to many • Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling

15. Evolution of home mortgage (Contd.) • To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages Bought loan Home loan funding Principal + interest payable over long term Cash Transfer of credit risk, market risk Borrower-Individuals Lender-Banks Had Access to long term borrowing Bought only those which conformed to certain underwriting standard ( called Prime Mortgages)

16. Evolution continued… • Fannie Mae proved very successful . But by 1960s , borrowing done by it constituted a significant share of the debt owed by US government. • 1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages. • Fannie Mae became federally chartered, privately held

17. Evolution continued • 1970- Ginnie Mae developed MBS (Mortgage backed by Securities) -- shifted the market risk to investors -- eliminated debt incurred to fund government housing program • 1970-Federal National Mortgage Corporation (Freddie Mac) created • To securitize conventional mortgages • Provide competition to Fannie Mae

18. Evolution Continued • Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage • Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it.

19. New Model of mortgage lending Bought loan Home loan funding Cash Transfer of credit & market risk Lender-Banks Principal + interest payable over long term Securitization fees SPV Cash MBS Transfer of market risk

20. New Model of mortgage lending (Contd.) • Advantages • More liquidity in market • Risk spread out • Long term funding for mortgage lending • MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make

21. Further evolution.. • 1977- Private label securitization started first done by BOA and Salomon Brothers • 1980s- pricing, liquidity and tax hurdles were resolved in same • Unlike 2-3 party , private label securitization has 10 or more different parties playing independent role

22. Further evolution • Big private players in this field were • Wells Frago • Lehman Brothers • Bear Stearns • JP Morgan • Goldman Sachs • Bank Of America

23. Details : Private Sub-prime mortgage process • 1. Brokers identify borrowers • 2. Originator and broker identify a loan for borrower after looking at his credit rating • 3. Formal application for loan by borrower • 4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller) • 5. Seller(Investment bank) collects a pool of loans and call it as SPV. Off balance sheet instrument

24. Details : Private Sub-prime mortgage process (Contd.) • 6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans • 7. Underwriter purchases all the securities (derivative income streams) • 8. In designing SPV and its tranches underwriter works with credit rating agencies

25. Details : Private Sub-prime mortgage process (Contd.) • 9. Underwriter then sells the securities to the investors • 10. High rated tranches might be guaranteed by a 3rd party insurance company • 11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights • 12. MERS – document custodian. Company to keep track of mountains of paper work on loans in the pool. At National level.

26. Reasons for forming of Subprime mess • Giant pool of money available for investment through savings of Oil exporters , economic development in BRIC countries. • Private share in mortgage market growth in large part through origination and securitization of high risk sub-prime and Alt-A mortgages. • Building up of the housing bubble • Private Banks made use of CDOs to sell to investors

27. Reasons for forming of Subprime mess (Contd.) • Lax regulations which did not keep pace with the innovations happening in financial engineering • US kept interest rates too low for too long in post dotcom bust period • Hedge funds, Wall street firms and instructional investors found lower tranches in MBS and CDO attractive which were highly risky • Hedge funds leverage ratio of the order of 500%. • To sum up in 3 words as noted by Harvard dean: Leverage(high), Transparency (low) and Liquidity (abundant)

28. Summary of this Session • Credit rating agencies • Mortgage Brokers • Secondary Mortgage Markets • The Mess • Evolution of Home Mortgage • New model of Mortgage lending • Private sub prime mortgage process • Reasons for forming of subprime mess

29. THANK YOU